Behavioural Finance

Question 1

5 belief-perseverance biases

(cognitive errors)

Answer 1

Conservatism

Representativeness

Illusion of control

Confirmation

Hindsight

Question 2

Conservatism bias

Answer 2

Maintains prior views / forecasts by inadequately incorporating new information

Overweights past information compared to new

Question 3

Consequences and mitigation of conservatism bias

Answer 3

Consequences:

• Slow to update view / forecast when presented with new information
• May choose to maintain prior belief than to deal with mental stress of updating beliefs when given complex data

Mitigants:

• Properly analyse and weight new information to dertemine its value (e.g. using Baye’s theorem)
• Seek professional advice if information is difficult to interpret

Question 4

Representativeness bias

Answer 4

New information is classified based on past experience or classification, such as using heuristics (e.g. if-then assumptions or rule-of-thumb), instead of rigorous analysis

2 types including: base rate neglect (overweights new info) and sample size neglect

Question 5

Consequences and mitigation of representativeness bias

Answer 5

Consequences:

• May lead to statistical or information-processing errors
• Could produce incorrect understanding that persists and biases all future thinking about the information

Mitigants:

• Better understand laws of probability and statistical analysis

Question 6

Illusion of control

Answer 6

When an individual thinks they can control or affect an outcome when they can’t

Question 7

Consequences and mitigation of illusion of control bias

Answer 7

Consequences:

• Leads to excessive trading > Increases transaction costs > Lowers overall portfolio returns
• Overconcentrate in own stock thinking they can control the outcome of the price

Mitigants:

• Objectively review past trades including all winning and losing trades to identify tendency

Question 8

Confirmation bias

Answer 8

Looks for (and notices) information that confirms their existing beliefs, and ignore or undervalue what contradicts their beliefs

Question 9

Consequences and mitigation of confirmation bias

Answer 9

Consequences:

• Could hold onto investment for tool long due to overconfidence in initial beliefs
• Example: Investor holding too much employer stock

Mitigants:

• Seek out contrary views and further information
• Re-evaluate after every change in company fundamentals

Question 10

Hindsight bias

Answer 10

Selective memory of past event, actions, or what was knowable in the past

Question 11

Consequences and mitigation of hindsight bias

Answer 11

Consequences:

• Tendency to see things as more predictable than they really are
• Results in excessive risk taking, overconcentration of stock positions
• Can become critical of the performance of others (because you “knew it all” along) and unfairly dismiss managers

Mitigants:

• Recognise and come to terms with own mistakes
• Record and objectively examine past investment decisions

Question 12

4 information-processing biases

(cognitive errors)

Answer 12

Framing

Anchoring & adjustment

Mental accounting

Availability

Question 13

Framing bias

Answer 13

Decisions are affected by the way in which the question or data is framed

Question 14

Consequences and mitigation of framing bias

Answer 14

Consequences:

• Fail to properly assess risk and end up overly risk-averse or risk-seeking
• Choose suboptimal risk for their portfolio / assets based on the way a presentation is made

Mitigants:

• Detect by asking whether one’s decision is based on realising a gain or a loss
• Acknowledge the imapct of loss aversion on one’s willingness to take risk
• Use more appropriate analysis e.g. compare current price to instrinsic value

Question 15

Anchoring & adjustment

Answer 15

Estimates probabilities based on an initial default view (anchor) which is adjusted up/down to reflect subsequent information and analysis

Overweight on statistically arbitrary, psychologically determined anchor points

Question 16

Consequences and mitigation of anchoring & adjustment

Answer 16

Consequences:

• May stick too closely to original estimates when new information is learned

Mitigants:

• Don’t rely on past prices or market levels to influence decisions
• Observe changes in company fundamentals
• Concentrate on the future potential of the company to influence buy/sell decisions

Question 17

Mental accounting

Answer 17

Money is treated differently depending on how it is categorised

Question 18

Consequences and mitigation of mental accounting

Answer 18

Consequences:

• Structuring investments into discrete buckets without regard for correlations among assets
• Failing to lower portfolio risk by combining assets with low correlation
• Overemphasis on income generating assets at the expense of eroding principal in the process, resulting in lower total return

Mitigants:

• Combine all assets into one summary to see the true asset allocation of various mental account holdings
• Create a portfolio strategy taking all assets into consideration
• Focus on total return, not just investment income

Question 19

Availability bias

Answer 19

Undue emphasis on the information that is readily available or easily recalled. Includes:

• Retrievability (easy to recall)
• Categorisation
• Narrow range of experience
• Resonance

Question 20

Consequences and mitigation of availability bias

Answer 20

Consequences:

• Choose manager / investment based on advertising or recalling names they’ve heard
• Limit investment choices to what’s familiar and fail to consider alternatives > Results in under-diversification and/or inappropriate asset allocation
• Overreact to recent market conditions while ignoring data on historic performance
• Over emphasis on events with large media attention/advertising

Mitigants:

• Maintain carefully researched and constructed IPS with appropriate research and analysis of all decisions and a long-term focus
• Ask “where did I hear this idea?”

Question 21

6 emotional biases

Answer 21

Loss-aversion

Overvonfidence

Self-control

Endowment

Regret-aversion

Status quo